States Borrowing to Boost Bottom Line

With interest rates skirting record lows and budget deficits approaching record highs, states are borrowing more money in order to close budget gaps, refinance old debt, spur on their economies and build new roads, schools and airports.

Over the first seven months of the year, state and local governments borrowed $230.1 billion, which is 18.2 percent more than they borrowed over the same period last year, according to The Bond Buyer.

"This year has been rocking and rolling," said Amy Resnick, editor-in-chief of The Bond Buyer.

More than a quarter of the borrowed money went to refinance old debt, much as homeowners are taking advantage of low interest rates to refinance mortgages, Resnick said. Most of the rest, roughly $154 billion, is what bond-insiders call "new money," which can be put toward a variety of uses.

States are using the bulk of this "new money" to fund large construction projects, such as roads and schools, that are considered investments in the future of the state, Resnick said.

A rarer and more controversial use is deficit financing, which enables states to close budget gaps by generating revenue now at a long-term cost to the state.

Bond analysts generally don't like this sort of deficit financing.

"They borrow long-term for a one-time purpose, so there's an immediate mismatch. It's like borrowing to pay a grocery bill. More highly rated states do not do that," said Nicole Johnson, an analyst with Moody's Investors Service, a bond-rating agency.

California took this step recently when lawmakers decided to borrow $10.7 billion as part of a solution for a $38 billion budget problem. The legality of this move may be challenged by the Pacific Legal Foundation, a conservative organization planning to sue the state to block the bonds.

"The state constitution prohibits what the Legislature and the governor are trying to do. The state constitution says major borrowing has to be approved by the voters," said Harold Johnson, an attorney with the group.

A number of states have also closed budget gaps by borrowing against future payments from the multi-billion dollar settlement with tobacco companies. This kind of borrowing is typically a bipartisan affair, with both Democrats and Republicans eager to avoid the deep spending cuts or large tax increases necessitated by budget deficits.

Last year, for example, Rhode Island traded $1.2 billion in future tobacco payments for up-front money to cover more than $200 million in deficits, according to the National Conference of State Legislatures (NCSL).

Tobacco settlement borrowing slowed down earlier this year after an Illinois judge ordered Philip Morris USA to post a $12 billion bond while appealing a court judgment against the company. Philip Morris, the biggest player in the state settlement, said it couldn't both post the bond and make payments to states, so the judge cut the bond in half.

Even with the reduction, the case unnerved state bond-buyers.

"That market pretty much dried-up. ...(The case) had a chilling effect on the market, because ratings on tobacco debt were dropped," Resnick said.

Facing a $5 billion budget deficit, Illinois lawmakers are issuing $10 billion in bonds to pay the state's pension obligations. A portion of the money, $2 billion will go directly into the pension fund, freeing up money to pay for other state programs. The rest of the bond money will be invested, hopefully generating enough revenue to pay the interest on the bonds and provide long-term pension income.

But if the returns come in at lower-than-needed levels, the state may have to use tax dollars to make up the difference.

Analysts said the recent up-tick in state borrowing is driven by low interest rates, which make borrowing cheap, and the pressing needs of cash-strapped states. For fiscal year 2004, which began July 1 in every state except Alabama, Michigan, New York and Texas, lawmakers were predicting aggregate budget deficits of more than $70 billion.

"When rates were at 40-year lows during the first part of the year through the end of June, borrowing was very attractive. For the same reason people were buying new homes, governments were borrowing new money," Resnick said.

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